UNDER the Indian Constitution, no tax can be levied or collected without the authority of law. This position holds good both for taxation of Indian residents as also taxation of non-residents. Very broadly speaking, under the Indian Income Tax, taxation of cross border business depends on the existence of a 'business connection' of the non-resident in India. What is business connection has not been exhaustibly defined. However, there is a long list of decisions from the Indian Courts that have laid down the broad proposition that there has to be a real connection between the business activity of the non-resident and India. A stray or occasional connection with India is not sufficient for taxing the non-resident's income in India.

In 1976, India tightened its source rules by bringing in the new rules for taxation of royalties and fees for technical services that were carved out of the business as special categories. However, the taxation of business income continued to pivot around business connection. Considering the growing integration of India with the global economy and the resultant exposure to the rules of international taxation, the government had set up a working group on taxation of non-residents in India. This working group, in the report submitted in January, 2003 inter-alia, suggested as follows:

"The term 'business connection' has been the subject of interpretation by various courts leading to watering down of the original intent of taxing the non-residents on the basis of their business connection in India. It is, therefore, recommended that the term business connection should be amended to also mean an agency PE , a concept provided for in many of our tax treaties. In other words the meaning of the term 'business connection' should include a person acting on behalf of the non-resident who:

a) has and habitually exercises in India an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non resident; or

b) has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non resident; or

c) habitually secures orders in India, wholly or almost wholly for the non-resident or for that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident.

The agency PE, however, should not be held to be established in cases where the non-resident carries on business through a broker, general commission agent or any other agent of an independent status, provided that such a person is acting in the ordinary course of his business."

Accordingly, in the budget 2003, a change was incorporated in the provision relating to business connection. Although it was still an inclusive definition, the concept of agency PE that is usually found in tax treaties was specifically brought in.

[Explanation 2.- For the removal of doubts, it is hereby declared that "business connection" shall include any business activity carried out through a person who, acting on behalf of the non-resident, - (a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident; or (b) has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident; or (c) habitually secures orders in India, mainly or wholly for the non-resident or for that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident:

Provided that such business connection shall not include any business activity carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business:

Provided further that where such broker, general commission agent or any other agent works mainly or wholly on behalf of a non-resident (hereafter in this proviso referred to as the principal non-resident) or on behalf of such non-resident and other non-residents which are controlled by the principal non-resident or have a controlling interest in the principal non-resident or are subject to the same common control as the principal non-resident, he shall not be deemed to be a broker, general commission agent or an agent of an independent status."

Now, as has been shown in the context of tax treaties in the BEPS project, it is quite possible for an agent to do all important work for the non-resident but not conclude the contract. This was an obvious lacuna and the BEPS report on Action 7 has recommended that when all elements of a contract are negotiated by the agent, the activity of the agent will constitute an agency of the non-resident. This is now reflected in the Multilateral Instrument that is supposed to replace the language of the existing tax treaties, if the other treaty partner also adopts it.

The language adopted in Article 12 of the MLI is as follows:

"1. Notwithstanding the provisions of a Covered Tax Agreement that define the term "permanent establishment", but subject to paragraph 2, where a person is acting in a Contracting Jurisdiction to a Covered Tax Agreement on behalf of an enterprise and, in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise , and these contracts are:

a) in the name of the enterprise; or

b) for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use; or

c) for the provision of services by that enterprise, that enterprise shall be deemed to have a permanent establishment in that Contracting Jurisdiction in respect of any activities which that person undertakes for the enterprise unless these activities, if they were exercised by the enterprise through a fixed place of business of that enterprise situated in that Contracting Jurisdiction, would not cause that fixed place of business to be deemed to constitute a permanent establishment under the definition of permanent establishment included in the Covered Tax Agreement (as it may be modified by this Convention).

2. Paragraph 1 shall not apply where the person acting in a Contracting Jurisdiction to a Covered Tax Agreement on behalf of an enterprise of the other Contracting Jurisdiction carries on business in the first mentioned Contracting Jurisdiction as an independent agent and acts for the enterprise in the ordinary course of that business. Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to any such enterprise."(Emphasis added)

It may be noted that in India, changing the tax treaties by themselves would not have conferred taxing rights on India considering the fact that tax can only be levied by the domestic law and in view of the peculiar section 90(2) that allows a taxpayer to choose between the provisions of the domestic law and a tax treaty whichever is more beneficial to the taxpayer. Therefore, the domestic law also had to be changed. This is precisely what the Finance Bill has done by modifying the existing definition of the business connection in section 9(1) as follows:

"(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident or habitually concludes contracts or habitually plays the principal role leading to conclusion of contracts by that non-resident and the contracts are- (i) in the name of the non-resident; or (ii) for the transfer of the ownership of, or for the granting of the right to use, property owned by that non-resident or that non-resident has the right to use; or (iii) for the provision of services by the non-resident "

A comparison of the language of the provision of the MLI and of the domestic law provision shows that the stipulation that the additional condition of conclusion of the contract without material modification as proposed in the MLI is missing in the proposed language. So, even if in the final contract there are some changes, if the agent has played a material role in the conclusion of the same, it will constitute business connection even though it may not lead to constitution of a permanent establishment.

There is another interesting aspect in the context of this change of an agency constituting a business connection. While replacing the existing explanation 2, the words 'unless his activities are limited to the purchase of goods or merchandise for the non-resident', has been omitted. So, if an agent only purchases goods or merchandise for a non-resident it is possible to conclude that such an agent will constitute a business connection of the non-resident.

It is interesting to note that long back in the context of the 1922 Act, the Supreme Court in the case of Anglo French Textiles had held that the acts of regular and systematic purchases of goods within British India for manufacture or sale outside British India would constitute profit bearing operations for the purpose of section 42(3) of the IT Act, 1922. [The legal position changed by an amendment made in 1964 and the profits attributable to profits attributable to purchase of goods for exports could not be taxed.]

It may also be noted that following the BEPS Action Plan 7, the auxiliary and preparatory exemption usually found in the OECD Model based tax treaties is to undergo a subtle change. Earlier purchase function was considered to be a preparatory function and a purchasing office would not have constituted a PE. This is now changed and the exception would now be available only if the overall activity is preparatory in nature.

The following example has been given to clarify the position:

RCO is a company resident of State R that is a large buyer of a particular agricultural product produced in State S, which RCO sells from State R to distributors situated in different countries. RCO maintains a purchasing office in State S. The employees who work at that office are experienced buyers who have special knowledge of this type of product and who visit producers in State S, determine the type/quality of the products according to international standards (which is a difficult process requiring special skills and knowledge) and enter into different types of contracts (spot or forward) for the acquisition of the products by RCO. In this example, although the only activity performed through the office is the purchasing of products for RCO, which is an activity covered by subparagraph d), paragraph 4 does not apply and the office therefore constitutes a permanent establishment because that purchasing function forms an essential and significant part of RCO's overall activity.

The change in the business connection is therefore in line with the international thinking in this regard. However, having established a business connection, it has then to be ascertained what profit can be attributed to the same. Explanation 1(b) of section 9 states that 'in the case of a non-resident, no income shall be deemed to accrue or arise in India to him through or from operations which are confined to the purchase of goods in India for the purpose of export .' This explanation continues with the result that no income will be deemed to accrue to the non-resident if its operations are restricted to purchase of goods in India for the purpose of export . In other words, if the purchase of goods in India is not for the purpose of export, income may accrue in India.

The other and the most significant change brought about by the budget 2018 in the area of the taxation of business income of non-residents is in the introduction of the concept of significant economic presence in the definition of business connection.

In the context of the BEPS Action Plan 1 relating to addressing the challenges of the digital economy, there was endless discussion about how to tackle the challenges posed by digitization in the existing international tax structure that basically requires a physical presence. As is now well known, one of the measures where there was near unanimity was the adoption of the concept of significant economic presence. Ultimately however, some of the developed countries scuttled the same. Nevertheless, it was also stipulated that countries could, introduce any of the three options of a significant economic presence PE, a withholding tax or an equalisation levy in their domestic laws as additional safeguards against BEPS, provided they respect existing treaty obligations, or in their bilateral tax treaties.

According to the Action1 Final Report on BEPS, the adoption of the options as domestic law measures could be considered if a country concludes that BEPS issues exacerbated by the digital economy are not fully addressed, or to account for the time lag between agreement on the measures to tackle BEPS at the international level and their actual implementation and application. According to the report, by adopting this approach, countries could address their concerns about BEPS in the short term and gain practical experience with the application of the options over time that can then be used to foster co-ordinated domestic law approaches in future.

India was the pioneer in adopting the equalisation levy in the budget 2016. It was possible to increase the scope of the same by notifying new services. Perhaps this was not considered to be a permanent solution and the government looked at other options. Although India has been at the forefront of the drive for change in the context of the digital economy, others are equally worried and are considering various options. Most notably, the EU is working on the same. Even if the problems arising from the digital environment have been discussed ad nauseum, it may still be worthwhile to note the observations of the EU Commission's report of 21.9.2017 in this regard:

"In the field of taxation, policy makers are struggling to find solutions which would ensure fair and effective taxation as the digital transformation of the economy accelerates. There are weaknesses in the international tax rules as they were originally designed for "brick and mortar" businesses and have now become outdated. The current tax rules no longer fit the modern context where businesses rely heavily on hard-to-value intangible assets, data and automation, which facilitate online trading across borders with no physical presence. These issues are not confined to the digital economy and potentially impact all businesses. As a result, some businesses are present in some countries where they offer services to consumers and conclude contracts with them, taking full advantage of the infrastructure and rule of law institutions available while they are not considered present for tax purposes. This free rider position tilts the playing field in their favour compared to established businesses."

It is also interesting to note that even though the USA is wants to maintain the status quo, many of its states are indeed collecting taxes on the basis of significant economic presence criterion even in the absence of physical presence. These are generally based on property, payroll or sales.

Israel has already introduced the concept of significant economic presence in 2016. According to a report in E&Y, in Israel, corporations which have a "Significant Digital Presence" in Israel may be subject to tax in Israel on said activity. The ITA understands this term to generally mean that while a given corporation may have no physical presence in a certain location, it may be considered as having a PE if it has the digital presence necessary to maintain client relations and a close relationship with clients.

[http://www.ey.com/Publication/vwLUAssets/Israeli_Tax_Authorities_publish_official_circular_on_internet_activity_of_foreign_companies_in_Israel/$FILE/2016G_00570-161Gbl_Israeli%20TAs%20publish%20official%20circular%20on%20internet%20activity%20of%20foreign%20companies%20in%20Israel.pdf]

Probably, considering these developments, the budget 2018 has also introduced the concept in the domestic law through a new Explanation 2A as follows:

'Explanation 2A.- For the removal of doubts , it is hereby clarified that the significant economic presence of a non-resident in India shall constitute "business connection" in India and " significant economic presence " for this purpose, shall mean– –

(a) transaction in respect of any goods, services or property carried out by a non-resident in India including provision of download of data or software in India , if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or

(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users as may be prescribed, in India through digital means :

Provided that the transactions or activities shall constitute significant economic presence in India, whether or not the non-resident has a residence or place of business in India or renders services in India :

Provided further that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India.'

The significant economic presence criterion can therefore be used even in the non-digitised environment. However, the threshold has not been finalized at this stage. It is specifically stated in the Memorandum that in treaty situations, nothing will change so long as the treaties are not amended. This seems to be therefore an enabling legislation in the domestic law. Eventually, if there is some agreement with treaty partners, it will be possible to change the same without the incomes escaping taxation under the domestic law itself. In the Indian context, it is important to emphasize that the domestic law should be tougher than treaty provisions. Bringing in the SEP concept will therefore improve the bargaining position of India. However, there are some limitations even in the newly introduced explanation like the stipulation that the transaction in respect of goods, services or property must be in India . This seems to be contrary to some of India's position elsewhere. All told, this is a bold beginning by India in the area of international taxation.